Monday, December 23, 2013

Time to Short Canada?

Camilla Hall of the Financial Times reports, Short-focused fund to launch in Canada:
Investors in Canada are to get the chance to bet against their own real estate market as one of the first short-focused funds is set to launch in the country, where concerns have grown that there is a housing bubble ready to burst.

The Spartan/Libertas Real Asset Opportunities Fund, set to launch in Toronto in the first quarter of next year, will allow Canadian brokers, developers or pension funds to mitigate their exposure towards a possible downturn in the real estate market, Michael Brown, manager of the fund told the Financial Times.

The new fund reflects broader investor interest in shorting or hedging risk to Canada after high-profile names from Steve Eisman, featured in Michael Lewis’s The Big Short, to Robert Shiller, the Nobel-prize winning economist, have raised questions over the challenges facing the Canadian real estate market.

Under the watch of Mark Carney, the former Bank of Canada governor who now holds the same job at the Bank of England, the country weathered the global financial crisis better than many industrialised peers. But low interest rates have encouraged soaring property prices and household debt levels which many economists say are unsustainable.

“The thesis behind the fund is that the Canadian housing market is one of the most overvalued in the world,” said Mr Brown. “A lot of things people observed in the US in the run-up to 2007-8 crisis are happening here.”

The OECD has ranked Canada as one of the countries most at risk of a price correction, especially if borrowing costs increase or income growth slows. Deutsche Bank recently said Canada is the most overvalued market in the world, with a 60 per cent overvaluation, above Belgium and Norway.

Canada’s average home price index has increased 20.2 per cent in the past 36 months, according to the Canadian Real Estate Association. Average existing home prices in Canada were at C$391,997 in November, 50 per cent higher than in the US, according to analysis by BMO Capital Markets.

Canada bears point to how low interest rates and the government’s backing of the mortgage market – by insuring home loans – have fuelled a real estate bubble and worse, stoked a consumer borrowing binge.

The ratio of household debt to disposable income has grown to 152 per cent in Canada, near to the US peak of 165 per cent, according to a December report from Canada’s central bank.

The level of the government’s involvement in the mortgage boom has drawn the attention of the International Monetary Fund, analysts and regulators as the portfolio of home loans insured by the Canada Mortgage and Housing Corporation has swelled to $560bn.

“When something gets that big, even governments get nervous,” Mr Eisman, founder of Emrys Partners told a conference in New York in May, attracting the attention of global investors.

But, since May, shares in mortgage company Home Capital Group – singled out by Mr Eisman – have increased more than 40 per cent and stocks of Genworth MI Canada have risen more than 30 per cent.

The new fund is being launched through Toronto-based Spartan, a multi-fund investment platform for individual hedge fund managers. Mr Brown was a managing director and partner of Enterprise Capital Management, a small, privately owned hedge fund sponsor.

While Mr Brown would not give specifics of the trades, the fund could look at strategies such as shorting equities or buying put options to bet on asset price declines, an alternative method of hedging.

It will bet on price declines across asset classes from equities, to fixed income and target sectors such as financial companies and real estate-linked companies, as well as the currency, said Mr Brown.

Goldman Sachs has recommended shorting the loonie, as the Canadian currency is known, as one of its top 2014 trades. In a separate report, Goldman also warned of the risks of overbuilding in Canada and said price declines could be “quite significant” in the event of a housing bust.

However, Canadian companies and banks are quite resolute in their rejection of the hedge fund bears and in particular, the comparisons they make with the US subprime mortgage crisis.

“[Canadian] Banks don’t lend money to people who can’t afford to buy houses and can’t afford to service the mortgages,” Gordon Nixon, chief executive of the Royal Bank of Canada told the Financial Times.
Damn those Goldman boys, they keep recommending my trades! For those of you who don't read this blog regularly, I've been warning my readers to short the loonie because the tailwinds that propelled it higher are no longer there (ie. massive Chinese investment in infrastructure bolstering commodities and commodity currencies) and the fundamentals in Canada are deteriorating quickly.

In a recent comment looking at whether Canada is on the right path, I noted the following:
As far as Canada's housing bubble, it keeps defying gravity but this too will come to an abrupt end. I know, there are millions of rich Chinese, Russian and Middle Eastern immigrants that will keep buying luxury condos for their kids to study in Canada and second homes for an insurance policy, but they will get clobbered along with everyone else investing in Canadian real estate at these prices.
Last night, I had dinner with my brother and friends and we talked about Montreal real estate. One of my friends who invests in affordable multi-family rental units noted: "Montreal's condo market is outrageously overpriced and high end condos, houses and cottages will be the first to get pummeled."

He also noted "Montreal is a poor city but people still need to live somewhere," which is why he prefers attractively priced apartment buildings. The problem is that there aren't many apartment buildings that offer an attractive yield, a point he underscored: "cap rates are ridiculously low."

I must admit, I've been bearish on Canadian real estate forever, fearing the worst from Canada's mortgage monster. Think it's grossly overvalued and a lot of young couples buying expensive homes or condos, taking out huge mortgages, will get slammed hard in the next few years. They are literally one job loss away from losing their home.

And the problem in Canada isn't just housing. Oil prices have fallen a lot over the past year (but have firmed up recently on good U.S. economic news). AIMCo recently invested $100 million in efficient oilsands technology but Leo de Bever, its President and CEO, isn't bullish on oil:
Alberta’s energy sector must learn to prosper in a world of much lower oil prices, warns Leo de Bever, CEO of Alberta Investment Management Corp., the province’s $70 billion public sector pension and endowment fund manager.

He believes the risks are high that oil prices will sink to the $70 US per barrel range or lower over the next five years, as North American output grows and demand wanes in the face of improved energy efficiencies. With West Texas Intermediate (WTI), the benchmark U.S. grade, now trading at more than $95 per barrel in New York, such a decline would represent a drop of 26 per cent from current levels. Western Canada Select, Alberta’s benchmark grade, is currently selling at just $66 per barrel.

As a result, AIMCo is looking to invest about $100 million in new, development-stage technologies that could help oilsands producers cut costs while addressing key environmental issues.

“If (WTI prices) go to $70 (US) a barrel, that’s a problem for Alberta, and the risks (of that happening) are pretty high,” de Bever said. “If this province is going to advance it has to deal with some of this. If we can bring the cost of refining down so we’re no longer the high-cost producer, we might give ourselves some options of not just shipping it to the Gulf but maybe refining more up here and shipping the high value-added stuff.”

In particular, AIMCo is trying to identify technologies that would use less energy to convert raw bitumen into synthetic crude.

“That usually means doing things at a lower temperature and lower pressure. That’s where all the costs are. I’m aware of four or five technologies that do that, and we’ve invested a little bit in two of them,” he said. “Maybe those two aren’t going to be the ones that carry the day, but there’s so many efforts being made in this regard that at some point somebody is going to punch through that wall, and the cost structure will come down quite dramatically.”

Since AIMCo’s primary goal is to generate solid returns for taxpayers, as opposed to funding development of new technologies that often don’t pay off, de Bever said he is “struggling with both how I can make money at it and do the right thing” for the Alberta economy.

That said, he emphasized that $100 million would equate to just a small fraction of AIMCo’s overall assets, which include the $16.6 billion Alberta Heritage Savings Trust Fund. AIMCo is currently on track to generate gains of more than 10 per cent for the full year, de Bever said.

“The overall numbers in terms of absolute return look pretty good, at over 10 per cent so far, with a 26 per cent increase in equities and zero or slightly negative (real) returns on bonds. The basic direction we took is we de-emphasized bonds and emphasized equities, and that has worked out for us. The only thing that’s a bit problematic is if you have unlisted assets as we do they tend to lag a big run-up like this, but eventually that will even out,” he said.

Asked whether he is worried about a sharp pullback in equity markets in view of the huge gains racked up by the major U.S. indexes this year, de Bever said he sees such corrections as longer-term buying opportunities.

“I have no doubt we’ll have stock market pullbacks as we’ve always had. But like Rip Van Winkle, if I were to wake up 10 years from now, I would rather have started out with a portfolio that’s more equities than bonds,” he said.

“There is tremendous opportunity in the long run in equities, and the dangers of being stuck in a holding pattern or worse for bonds is high. There’s only two scenarios for bonds: terrible and really terrible. I can’t conceive of a bond scenario that really generates a lot of capital gains going forward.”
There are tons of opportunities in equities and as I stated in my comment on Fed tapering and deflation, you better buy any dip in the stock market hard because the risks of a significant melt-up in stocks is high, fueling more bubble anxiety.

Nonetheless, I'm not as bearish on bonds as Leo de Bever and other pension funds betting massively on a rise in interest rates. I still fear deflation is the end game and after we get the mother of all liquidity rallies in risk assets, the next cycle will be prolonged debt deflation.

AIMCo's investment in this new technology is interesting but it's a pittance for their overall portfolio. I found it more interesting that they recently bailed out of Precision Drilling (PD.TO), prompting one analyst, Andrew Bradford of Raymond James, to upgrade their shares (update: AIMCo took profits and stock kept going higher. As of June 2014, it's at $16).

As far as Canada's energy sector, I warned my readers in early January about Canada's perfect storm, noting the following:
As for the great Canadian oil glut, it couldn't have come at a worse time. Coupled with the great Canadian condo glut, there is a perfect storm brewing up here which will seriously impact our economy for a long time (start shorting the loonie!). It's déjà vu all over again for Alberta as they haven't learned anything from the last oil boom & bust episode.
If you took my advice and shorted the loonie at the beginning of the year, you would have made a killing, just like if you took my advice and shorted the yen when I wrote about Japan's seismic shift in November 2012, you would made off like a bandit (I should run the research at a top global macro fund).

So what is the best way to short Canada? I still think it's better to short the loonie and selective commodity and energy companies rather than shorting Canadian banks, but if you're long Canadian banks, book your profits and go neutral or underweight after the record run-up. Looking ahead, I prefer U.S. banks over Canadian banks but think the latter are still well managed (some better than others).

Finally, it is worth noting the Caisse's CIO, Roland Lescure, doesn't think investors should bet against boring Canada. I respectfully disagree and note the Caisse hasn't made serious money trading currencies in all but one year in the last 20 years (their currency strategists have been extremely poor performers). The Caisse is also betting big on emerging markets, which might pan out or flop spectacularly (tough call).

Below, Mike Babad, the Globe and Mail's Report on Business News Editor, reports on why analysts can't agree on a Canadian housing bubble. I fear the worst for Canada and think economists expecting a "soft landing" in the Canadian real estate market are delusional fools. You've been warned.